The Individual Retirement Account or IRA was created in 1974 to encourage workers to save more for retirement. Today IRA accounts are ubiquitous, numbering 26 million accounts holding $2.5 trillion. Still, much confusion reigns regarding the various flavors. Traditional, rollover, Roth: what’s the difference? Here’s a brief primer as tax time approaches.
Photo — Please put this mug shot of Chris Hopkins of Barnett & Co. in our system to use every other Wednesday when it will run with his column.The original IRA account allowed workers to stash up to $1,500 per year regardless of income. By 1986, the limit had increased to $2,000 but income caps were imposed. This so-called “traditional” IRA provided a means for many workers to make a tax-deductible contribution to their own retirement that would be allowed to grow over time sheltered from taxation. Only upon withdrawal in retirement would the assets be taxed, typically at a lower marginal rate. The main problem was the persistently low annual limit, which for many years stagnated at $2,000 while inflation effectively halved the real value of that amount.
By far the most prevalent incidence of the IRA was to serve as a receptacle for company retirement plan assets once a worker left the company sponsoring the plan, effectively making retirement savings portable. This variety was known as a “rollover” IRA or a “conduit” account, created expressly to receive 410(k) and other plan assets. These rollover accounts were originally segregated from traditional IRAs in part because many plans allowed after-tax, non-deductible contributions that had to remain separate in the post-plan IRA.
Today, the distinction is largely academic and assets including after-tax contributions may be readily rolled into traditional IRAs. Some custodians are eliminating the term “rollover” altogether.
If you are married filing jointly and have adjusted gross income less than $98,000, you may make a tax-deductible contribution of $5,500 for each spouse even if you have a retirement plan at work. If you are age 55 or over, you can add another $1,000 each as a catch-up provision.
Roth IRAs are an entirely different kettle of fish. Sen. William Roth of Delaware devised and promoted the eponymous retirement account in 1997 as additional incentive for Americans to save.
Subject to the same contribution limits as traditional accounts, Roth IRAs allow only after-tax contributions (non-deductible). Furthermore, one may make the full Roth contribution only if joint income falls below $184,000. However, once the account is funded, any growth in the investments may be withdrawn totally tax-free after five years and attaining age 59 1/2. And your Roth account is exempt from the mandatory withdrawal rules at age 70 1/2 that the traditional IRA requires.
While contributions are not deductible, tax season is still a good time to contemplate a Roth. You may choose to convert traditional IRA account assets into a Roth, including the amount converted as ordinary income on your tax return. This strategy is not for everyone, and is most beneficial for younger taxpayers with long time horizons to maximize the tax-free growth. But if you wish to pass tax-free assets to the next generation and avoid the required minimum distribution at 70 1/2, conversion may make sense. This is especially true if you find yourself between age 60 and 70 and benefit from a low tax bracket.
Finally, if you completed a Roth conversion last year and have suffered investment losses, you may be able to get a do-over. Un-conversions or “recharacterizations” are allowed up through Oct. 15 of the year after the conversion. After a 30-day wait, you can re-convert at the new value and possibly reduce your tax bill.
Obviously you should consult your tax adviser to determine the optimal strategy. But no matter, traditional or Roth, you really can’t go wrong as long as you are saving.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.